In an article in the last edition of the WIRE, we wrote on the likely effects of the then-nascent Tariff war between the US and Canada (and Mexico and China). Since then, the tit-for-tat tariffs have increased, along with item-specific tariffs and reciprocal tariffs. It’s all a bit of a mess. The markets have started to notice but have not fully bought into the story. The reverberations of the tariff war are being felt across the globe, but so far the impacts have been somewhat unequal. This edition we explore the effect of American tariffs on the rest of the world.
Another major period of action appears to be starting in the US trade wars. As I write, as well as increases to the US tariffs on imported goods from Canda we have deliberately painful Canadian reactions targeting particular US states. There’s also the broad-based tariffs coming into effect on the whole world for certain products – Australia will be caught up in these steel and aluminium tariffs.
Unlike when looking at the US directly, understanding the effect of US tariffs on the rest of the world is mostly about second and third order effects, and weighing up which effect is going to be the strongest. The pure theory says that the impact on Australia should be minimal and mostly via the conduit of China.
The steel and aluminium tariffs will matter, at the margin, but since they are globally applied, Australia’s relative position hasn’t changed too much. We will now be less competitive than US domestic producers in the domestic market, however, since we have no country-specific tariffs, we will be more price competitive than Canadian products. It’s all very messy and when the rules change every few weeks it’s hard to know precisely what the final rules will be. That’s part of the problem for many companies, of course. They are trying to plan major supply chains, and the rules keep changing.
While the direct impact on Australia is minimal, so far, we also need to remember the aphorism about “when the US sneezes the world catches a cold”. Even if a US recession (which now can’t be ruled out, even according to President Trump) shouldn’t directly impact Australia too much, we suspect that the financial market ramifications of a US recession would be very important for Australia.
Let’s start with the theory. If the US engages in a number of reciprocal trade wars with its major trading partners, then Australia is quite a long way down the list of targets. We do relatively little direct trade with the US (or Canda or Mexico). At present, the main headlines are focusing on the US-Canada and US-Mexico elements of this, with the US-China elements being much less prominent in global headlines. The US initially raised the tariffs on China by 10%, which saw China immediately retaliate, then the US implemented a further 10% tariff.
As we discussed last time, the net effect of the tariffs between China and the US are likely to be for lower growth and higher inflation in both countries as the trade between them falls.
Australia does a lot of trade with China, obviously, as both an importer and an exporter. Our key export to China is iron ore. In 2023 the iron ore was worth AUD79.4bn out of a total of AUD120bn. Coming in next on the list are some other mining products, then some food items.
At a direct item level, very little of what Australia exports gets re-exported to the US. So any chilling of exports from China to the US won’t directly impact Australian exports, but there will be many indirect effects. The iron ore that Australia exports to China ends up as steel that is used in China’s ongoing industrialisation and urbanisation. As the Chinese economy slows there will be less demand for the raw materials for construction and urbanisation. That decrease in exports to China would cause a slowing of Australia’s economy overall. The iron ore exports provide a relatively large amount of revenue to the Australian Federal Government, so you would likely also see an increase in the Federal deficit and – possibly – a reaction from whichever Government wins the coming election.
However, we ought to consider both sides of the equation. If the tariffs on the US are causing the Chinese exports to the US to slow, then there will be a lot of Chinese consumer goods that cannot enter the US that are looking for someone to buy them. Australia would appear to be an obvious target market. In the short-term there is some risk of dumping of consumer items into Australia as an alternative market.
So the theory says that Australia should have relatively mild effects, mostly via the conduit of China. We should see slightly weaker growth and slightly lower inflation. However, because Australia is mostly not directly participating all, the theoretical impacts are second and third order effects, meaning the actual impact on Australia is relatively muted.
This all assumes that Australia remains uninvolved in the argument between the US and others. Last time around Australia did get involved on the side of the US, generally speaking, and so triggered some reactions from China. However, the last trade war the US mounted had slightly more solid foundations. The Chinese structures and regulations around foreign investment are dubious, to say the least, and the US had reasonable grounds to object to them. However, arguments around fentanyl appear to be a fig-leaf. If the US and China let us, I’m sure Australia would be more than happy to stay on the sidelines if we possibly can, regardless of who wins the election.
In summary, the direct effect of the current US tariff wars on Australia is reasonably minimal. The largest effect would be via a slowing in the Chinese economy leading to reduced demand for Australian raw materials, with some prospect of dumping of Chinese manufactured goods here as the exports to the US slow. Overall, you would expect both reduced economic activity and possibly reduced inflation too, though so long as Australia remains on the sidelines of any trade war, these direct effects should be minimal.
There are two other lines of argument to consider, though.
First, a severe recession in the US has impacts on global demand and supply. The US is around 15% of the global economy in purchasing power parity terms. As a major consumer of basically everything, a significant slowing of the US economy would help materially lower global demand and hence global inflation. We’ve just spent a few years talking about the way that global supply needed time to catch up to global demand. If there’s a material US slowdown then suddenly global demand is lower and inflation should fall everywhere. This would impact Australia too. An obvious example would be to think about something like petrol prices in the context of a material slowing of the US economy. It would cause lower prices in Australia.
This line or argument also applies to the other controversial US policy at present, namely the significant reduction of the US Government spending via public service job cuts and, possibly, welfare cuts. The internal results of a foreign country’s domestic policy do not usually impact on Australia. But for a country as big as the US the result would be enough to affect the global economy. (For those who studied economics, Australia is a small open economy, but the US is not “small”, it is a large economy that is, for the moment, open.)
Second, a severe recession in the US would impact the world via the “market confidence” channel. Even if there wasn’t an impact on global supply and demand from a material US recession, there would be a phenomenal impact on the rest of the world from the way the US financial markets influence other global markets.
When we wrote a couple of weeks ago, the US share market was just starting to be affected and the US 10Y bond yield had dropped a touch but remained within trading ranges. Over the last little while the bond yields have dropped further while the US equity markets have fallen significantly.
We expect the fall to continue if the Trump administration pushes forward with both these polices on tariffs and austerity. For the moment the commentary is mostly focused on the tariffs but the austerity program will also affect the US economy. Which precise policy is driving the movement matters, because tariffs tend to cause lower growth and higher inflation, while austerity causes lower growth and lower inflation. Equity markets tend to fall in both scenarios, but bond yields will be held up by tariffs and inflation, but free to fall in the austerity scenario. So far the impact of US tariffs has been mostly around a freezing up of confidence. It’s not that the tariffs themselves are altering behaviour, rather it’s the uncertainty regarding what the rules will be. That chilling effect slows the economy without the impact of tariffs to raise inflation. In the short-term at least, this means US bond yields can fall. But at the times where the actual tariffs themselves are imposed you can see jumps in yields related to the inflation risk. You get significant volatility.
In Australia, the falls in the US equity markets have been large enough to trigger sympathetic falls in the Australia stock market.
However, Australian bond yields have been relatively stable. There’s been something of a down-trend but nothing too dramatic and certainly nothing that matches the US. We suspect that’s because the RBA has been aggressively talking up the economy as a way to limit market assumptions about ongoing near-term rate cuts. However, if the current US moves continue, then the Australian bond yields will fall, perhaps significantly, because rate cuts will be the appropriate response.
The RBA has been concerned about a re-awakening of inflation, but that seems unlikely in Australia if there is a material slow-down in economic activity in the US, China, Canada and Mexico. As inflation fades as a risk the RBA would have scope to lower yields more in Australia.
At present, the US bonds are moving lower faster than Australian ones, but we think that’s because the US market is more closely paying attention to this developing dynamic.
Overall, we’d think that the lowering of Australian bonds could be larger than the lowering of US bonds, since US bonds will be torn between the two halves of the tariff’s final stagflationary outcome. Namely, lower growth but higher inflation. Meanwhile in Australia, we would see the stagnation effects of a US stagflation outcome and probably also a fall in inflation locally. We’d expect Australian bonds to outperform in a mild US recession scenario. Only if the US recession becomes extremely bad would the US rally out-do Australia. So far, the Australian bonds have remained “above the fray” and haven’t moved too far. That sort of gravity-defying can only last so long, however.
If the current uncertainty in the US persists – and all indications suggest it will – the Australian bond market will eventually be affected, leading to a decline in yields. In our January outlook we recommended clients be BOLD and look to buy duration ahead of a turn in the cycle and also to be decisive when the opportunities present. We think both those pieces of advice apply to the current situation. The US market is reflecting a changing global economy and a weakening growth pulse. The Australian bond market has not quite caught up yet – but we think it is going to.